Question

Downton Ltd signs a non-cancellable five-year lease on an item of machinery on 1 July 2018. At the inception of the lease, the machinery has a fair value of $801,060.

The expected economic life of the machinery is six years, when it is expected to have a residual value of nil. There is a bargain purchase option that Downton Ltd, as the lessee, will be able to exercise at the end of the fifth year of the lease for $300,000.

There will be five annual payments of $200,000, the first being made on 30 June 2019. Included within each of the $200,000 payments is an amount of $25,000 which will be paid to the lessor to cover insurance and maintenance on the equipment. There were no initial direct costs associated with the lease. The equipment is to be depreciated on a straight-line basis.

The interest rate implicit in the lease is 12%.

Required:

1. Prove that the interest rate implicit in the lease is 12%. Show workings.
2. Prepare a schedule of lease payments for the duration of the lease in the following format.          Round to whole numbers.

Date	Beginning balance	Lease payment	Interest expense	Principal repayment	Closing balance

3. Prepare the journal entries to record the inception of the lease on 1 July 2018.
4. Prepare the journal entries on 30 June 2019.   

Answer 1

i)	PV of the lease rent = (200000-25000)*3.6048 =	$             6,30,840
	PV of bargain purchse price = 300000*0.5674 =	$             1,70,220
	PV of the lease payments	$             8,01,060
	As the PV of lease payments equals the fair value of
	machinery at a discount rate of 12%, 12% is the
	implicit rate of the lease.
ii)	Date	Beginning balance	Lease payment	Interest expense	Principal repayment	Closing balance
	06/30/2019	801060	175000	96127	78873	722187
	06/30/2020	722187	175000	86662	88338	633850
	06/30/2021	633850	175000	76062	98938	534912
	06/30/2022	534912	175000	64189	110811	424101
	06/30/2023	424101	474993	50892	424101	0
iii)	Leased asset	801060
	Lease liability		801060
iii)	Lease liability	78873
	Interest expense	96127
	Insurance and maintenance expenses	25000
	Cash		200000
	Depreciation expense (630840/5)	126168
	Accumulated depreciation (Leased asset)		126168